Apple sparks renewed interest in dividend-paying stocks

Apple made headlines again last week, but this time they weren't entirely about the new iPad.

The tech behemoth announced that it would start paying a quarterly dividend worth $2.65 per share beginning in July. That amounts to nearly $10 billion to be paid out in the first year alone.

"Apple is the leader here," says Howard Silverblatt, senior index analyst with Standard & Poor's, who adds that the company will put pressure on other technology firms to start paying dividends.

Dividends usually are awarded by well-established companies that no longer need every dollar to grow. But dividends fell out of favor in the bull market of the 1990s, when investors cared more about rising stock prices. Now, with incredibly low interest rates and after a decade in which stock prices went nowhere, investors have begun to appreciate the cash.

As payouts gain in popularity, investment professionals say it's harder to find dividend-paying stocks at attractive prices. Experts also raise concerns that investors might be underestimating the risk of these stocks.

And as investors rush to collect dividends, another factor should be considered: Most dividend income is taxed now at no more than 15 percent, but this favorable rate is set to expire at the end of the year.

Still, even with these potential drawbacks, dividends can play an important role in a portfolio. You just need to make sure that the stock is an appropriate fit and that the company is committed to maintaining — and increasing — the dividend over time.

Silver Spring financial planner Denise Leish says holding stocks with dividends is like owning rental properties — with paying tenants. She started buying dividend-paying stocks four years ago as interest rates fell and as her clients approached retirement and wanted more income to supplement their pensions.

A record 22 firms in the S&P 500 index launched dividends last year, Silverblatt says. He expects that companies in the index will pay out $277 billion in dividends this year, a 15 percent increase over last year.

And mutual funds with a focus on dividend-paying stocks also have sprung up. Chicago-based Morningstar tracks 45 U.S. funds with an emphasis on dividends — 16 of which were launched last year.

This summer, Apple will become the second-largest dividend payer, behind AT&T, Silverblatt says.

Apple is sitting on nearly $100 billion in cash.

"They had so much cash and so much pressure to do something," says Chuck Carlson, editor of the DRIP Investor newsletter. "Why not give it back to shareholders?"

Dividends are measured in terms of yield. That's calculated by dividing the dividend by the stock price. In Apple's case, the dividend yield is 1.8 percent, which is similar to what other tech companies offer, Silverblatt says.

Others had higher expectations of Apple.

"It's better than nothing, but I'm still not that impressed," says Josh Peters, editor of Morningstar DividendInvestor newsletter. Peters says Apple could pay a 6 percent yield and still have enough cash to grow its business as quickly as it does now.

"Is Apple a great dividend play? The answer to that is no," Peters says. He expects that Apple will continue to raise the dividend and that it will be more meaningful over time.

But for investors who want a portfolio that generates income, he recommends choosing companies that have paid dividends for a decade or more.

"There, you know that the dividend is a priority," he says.

Apple offered a dividend years ago, but canceled it in 1995, the year before Steve Jobs — no fan of dividends — returned to the company.

"For Apple, you don't know. They can change their mind," Peters says. "You can't have the same confidence of what to expect."

Maybe Apple isn't for you — especially at more than $600 per share. But if you're interested in other dividend-paying stocks, do some homework. To reap the benefits of dividends quarter after quarter, you must hold onto the stock for the long term. So make sure it's a stock that fits your portfolio.

Carlson says he looks for stocks with yields of 1.5 percent to 4 percent. A company offering a yield much higher than its peers could be a red flag — such as a plunging stock.

Say a $20 stock pays a $1 annual dividend — a 5 percent yield. But if that stock plummets to $5, suddenly the yield jumps to 20 percent.

Make sure the company has the cash to continue dividends. Carlson measures this by the payout ratio, which is the yearly dividend divided by the annual earnings per share.

If the annual dividend is $1 and the company earned $2 per share, the payout ratio is 50 percent. In other words, half the company's profit goes toward dividends.

Carlson says that, with a few exceptions, he is wary of companies paying out more than 60 percent of their income profits in dividends because they might not be able to sustain that.

And look for companies with a long history of paying dividends — and of increasing them by 5 percent to 10 percent a year, Carlson says. He adds that it seems more companies than usual areraising dividends by double-digit percentages this year.

Financial planner Leish says the prices of many dividend-paying stocks have been bid up by income-hungry investors.

Investors will have to look beyond the traditional dividend-paying stocks, Leish says. She invests in real estate investment trusts and master limited partnerships, both of which get special tax treatment and must pay out most of their income to investors. The yields today are about 6 percent or 7 percent, she says.

Be aware, these dividends are taxed as regular income.

But regular dividends also are set to lose their favorable tax treatment after this year, causing concern among investors, says Bill Allen, vice president with Charles Schwab Private Client Investment Advisory Inc.

Allen advises clients to make sure they have income from a variety of sources that are taxed differently.

"If all [income] comes from dividend-paying stocks, you're really at risk for any changes that might happen," he says.

Joe Davis, head of the investment strategy group at Vanguard, says some investors are so focused on dividends that they ignore a stock's potential to rise in price — which is more important to their total return.

"You don't want to focus on any one component," he says. "Look at it holistically."

Allen and Davis are concerned that investors are using dividend-paying stocks as a substitute for bonds, making their portfolios much more aggressive than they realize.

"At the core, a dividend-paying stock is a stock and will act like a stock," Allen says.

As long as investors understand this, they can benefit from dividends. And if the experts are right, more companies will be adding dividends.